1 of 40 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 9 The Government and Fiscal Policy Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d ) The Determination of Equilibrium Output (Income) Fiscal Policy at Work: Multiplier Effects The Government Spending Multiplier The Tax Multiplier The Economy’s Influence on the Government Budget Automatic Stabilizers Looking Ahead Appendix A: Deriving the Fiscal Policy Multipliers

2 of 40 © 2014 Pearson Education, Inc. fiscal policy The government’s spending and taxing policies. monetary policy The behavior of the Federal Reserve concerning the nation’s money supply.

3 of 40 © 2014 Pearson Education, Inc. discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government. disposable, or after-tax, income (Y d ) Total income minus net taxes: Y − T. disposable income ≡ total income − net taxes Y d ≡ Y − T Government in the Economy Government Purchases (G), Net Taxes (T), and Disposable Income (Y d )

4 of 40 © 2014 Pearson Education, Inc.  FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

5 of 40 © 2014 Pearson Education, Inc. The disposable income (Y d ) of households must end up as either consumption (C) or saving (S). Thus, Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity: By adding T to both sides: Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), planned investment by business firms (I), and government purchases of goods and services (G).

6 of 40 © 2014 Pearson Education, Inc. budget balance The difference between what a government collects in taxes and what it spends in a given period: T − G. budget balance ≡ T − G budget surplus if T − G > 0 budget deficit if T − G < 0 balanced budget if T − G = 0

7 of 40 © 2014 Pearson Education, Inc. To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write C = a + bY d or C = a + b(Y − T) Our consumption function now has consumption depending on disposable income instead of before-tax income. Adding Taxes to the Consumption Function

8 of 40 © 2014 Pearson Education, Inc. The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Planned investment depends on the interest rate, both of which we continue to assume are fixed for purposes of this chapter. Planned Investment

9 of 40 © 2014 Pearson Education, Inc. Y = C + I + G TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100 (1)(2)(3)(4)(5)(6)(7)(8)(9)(10) Output (Income) Y Net Taxes T Disposable Income Y d ≡Y −T Consumption Spending C = Y d Saving S Y d – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequi- librium − − 150Output ↑ − 100Output ↑ − 50Output ↑ Equilibrium 1, , , Output ↓ 1, ,2001, , Output ↓ 1, ,4001, , Output ↓ The Determination of Equilibrium Output (Income)

10 of 40 © 2014 Pearson Education, Inc.  FIGURE 9.2 Finding Equilibrium Output/Income Graphically Because G and I are both fixed at 100, the aggregate expenditure function is the new consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900.

11 of 40 © 2014 Pearson Education, Inc. saving/investment approach to equilibrium: S + T = I + G To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE). By definition, AE equals C + I + G, and by definition, Y equals C + S + T. Therefore, at equilibrium: C + S + T = C + I + G Subtracting C from both sides leaves: S + T = I + G The Saving/Investment Approach to Equilibrium

12 of 40 © 2014 Pearson Education, Inc. At this point, we are assuming that the government controls G and T. In this section, we will review three multipliers: Government spending multiplier Tax multiplier Balanced-budget multiplier Fiscal Policy at Work: Multiplier Effects government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. The Government Spending Multiplier

13 of 40 © 2014 Pearson Education, Inc. TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here) (1)(2)(3)(4)(5)(6)(7)(8)(9)(10) Output (Income) Y Net Taxes T Disposable Income Y d ≡Y −T Consumption Spending C = Y d Saving S Y d – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequilibrium   200 Output ↑  150 Output ↑  100 Output ↑  50 Output ↑ 1, , ,1000Equilibrium 1, ,2001, , Output ↓

14 of 40 © 2014 Pearson Education, Inc.  FIGURE 9.3 The Government Spending Multiplier Increasing government spending by 50 shifts the AE function up by 50. As Y rises in response, additional consumption is generated. Overall, the equilibrium level of Y increases by 200, from 900 to 1,100.

15 of 40 © 2014 Pearson Education, Inc. tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. The Tax Multiplier Because the initial change in aggregate expenditure caused by a tax change of ∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution: Because a tax cut will cause an increase in consumption expenditures and output and a tax increase will cause a reduction in consumption expenditures and output, the tax multiplier is a negative multiplier:

16 of 40 © 2014 Pearson Education, Inc. TABLE 9.3 Finding Equilibrium after a tax decrease of 50 (T Has dncreased from 100 in Table 9.1 to 60 Here) (1)(2)(3)(4)(5)(6)(7)(8)(9)(10) Output (Income) Y Net Taxes T Disposable Income Y d ≡Y −T Consumption Spending C = Y d Saving S Y d – C Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change Y − (C + I + G) Adjustment to Disequi- librium − − 180Output ↑ − 130Output ↑ − 80Output ↑ Output ↑ 1, Output ↓ 1,300601, Output ↓ 1,500601, Output ↓ Can you find the equilibrium Y?

17 of 40 © 2014 Pearson Education, Inc. TABLE 9.4 Summary of Fiscal Policy Multipliers Policy StimulusMultiplier Final Impact on Equilibrium Y Government spending multiplier Increase or decrease in the level of government purchases: ∆G Tax multiplierIncrease or decrease in the level of net taxes: ∆T

18 of 40 © 2014 Pearson Education, Inc. automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. The Economy’s Influence on the Government Budget Automatic Stabilizers and Destabilizers

19 of 40 © 2014 Pearson Education, Inc. automatic stabilizers budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income (Y d ) fiscal policy government spending multiplier monetary policy net taxes (T) tax multiplier Disposable income Y d ≡ Y − T AE ≡ C + I + G Government budget deficit ≡ G − T Equilibrium in an economy with a government: Y = C + I + G Saving/investment approach to equilibrium in an economy with a government: S + T = I + G Government spending multiplier Tax multiplier ≡ R E V I E W T E R M S A N D C O N C E P T S

20 of 40 © 2014 Pearson Education, Inc. CHAPTER 9 APPENDIX A Deriving the Fiscal Policy Multipliers The Government Spending and Tax Multipliers We can derive the multiplier algebraically using our hypothetical consumption function: The equilibrium condition is By substituting for C, we get This equation can be rearranged to yield Now solve for Y by dividing through by (1 − b):